IRS explains new UBTI rules: Clearing up the “silo rule” confusion

Several provisions of the Tax Cuts and Jobs Act (TCJA) have significant implications for nonprofits, especially those with unrelated business taxable income (UBTI). These organizations must now calculate their UBTI separately for each unrelated business.

Not surprisingly, this new “silo rule” has led to some head-scratching. The IRS has issued interim guidance to eliminate the perplexity. Nonprofits may rely on this guidance (IRS Notice 2018-67) until proposed regulations are issued.

Calculating total UBTI

Before passage of the TCJA, nonprofits with multiple unrelated businesses could aggregate income and deductions from those activities. As a result, they could offset income from one business with deductions from another. And that reduced their total UBTI.

The TCJA requires nonprofits to calculate UBTI for each business separately. Now, an organization’s total UBTI is the sum of the UBTI for each business, less the $1,000 “specific deduction” generally allowed when computing UBTI. In other words, the specific deduction doesn’t come into play until the individual UBTI amounts are totaled, not when computing those individual amounts.

Identifying separate businesses

The TCJA doesn’t provide criteria for determining whether a nonprofit has more than one unrelated business. Nor does it describe how to identify separate unrelated businesses. The IRS plans to propose regulations addressing these issues. In the meantime, it will allow organizations to apply a “reasonable, good-faith” standard based on all of the facts.

For example, the guidance states that nonprofits can use the North American Industry Classification System (NAICS) codes to determine if they have more than one unrelated business. Nonprofits already are required to use the codes when identifying unrelated businesses for IRS Form 990-T, “Exempt Organization Business Income Tax Return.”

The guidance also notes that the “fragmentation principle” for separating exempt and nonexempt activities could prove helpful. This principle generally provides that an activity doesn’t stop qualifying as a business merely because it’s conducted within a context of exempt activities. For example, selling ad space in your magazine is considered a business even though the magazine also has content related to your exempt purpose.

Accounting for partnership income

The IRS guidance provides several interim and transition rules for investments in partnerships where a nonprofit doesn’t significantly participate in any of the partnership’s business (for example, investments in private equity funds). Some organizations had worried they would need to calculate UBTI separately for each unrelated business the partnership conducts.

Until the IRS issues proposed regulations on the topic, you can aggregate the UBTI from your interest in a single partnership that has multiple unrelated businesses under an interim rule. That’s as long as the partnership interest satisfies one of two tests:

  1. Under the de minimis test, your organization can hold no more than 2% of the partnership’s profits interest or capital interest.
  2. Under the control test, the nonprofit can hold no more than 20% of the partnership’s capital interest and can’t have control or influence over the partnership.

Additionally, a transition rule allows you to treat any partnership interest acquired before August 21, 2018, as a single business, regardless of whether it meets one of the tests or conducts more than one trade or business.

And that’s not all

The interim guidance covers several other topics related to the calculation of UBTI, including the use of net operating losses, effect of transportation fringe benefits, inclusion of certain investment and insurance income, and income generated from debt-financed properties. Your financial advisor can help you decipher the rules and stay in compliance. 

SIDEBAR: New UBTI provisions carry high cost for nonprofits

Research commissioned by Independent Sector and conducted by the Urban Institute and George Washington University indicates that two provisions of the Tax Cuts and Jobs Act (TCJA) addressing unrelated business taxable income (UBTI) will divert thousands of dollars from nonprofit missions. The findings are based on a survey of more than 700 nonprofit organizations.

The survey found that the new 21% federal tax on transportation fringe benefits, including transit and parking, will redirect an average of about $12,000 away from each nonprofit’s mission per year. About 10% of respondents reported that they’re considering dropping transportation benefits altogether, because of the changes in their tax treatment.

The survey also examined the effects of the TCJA’s requirement that nonprofits report unrelated business profits and losses separately for each activity. (See the main article.) According to the survey, this change will result in an average of about $15,000 in additional new taxes per organization.